Brazil’s presidential election

Jair Bolsonaro, Latin America’s latest menace

He would make a disastrous president

“GOD is Brazilian,” goes a saying that became the title of a popular film. Brazil’s beauty, natural wealth and music often make it seem uniquely blessed. But these days Brazilians must wonder whether, like the deity in the film, God has gone on holiday. The economy is a disaster, the public finances are under strain and politics are thoroughly rotten. Street crime is rising, too. Seven Brazilian cities feature in the world’s 20 most violent.

The national elections next month give Brazil the chance to start afresh. Yet if, as seems all too possible, victory goes to Jair Bolsonaro, a right-wing populist, they risk making everything worse. Mr Bolsonaro, whose middle name is Messias, or “Messiah”, promises salvation; in fact, he is a menace to Brazil and to Latin America.

Mr Bolsonaro is the latest in a parade of populists—from Donald Trump in America, to Rodrigo Duterte in the Philippines and a left-right coalition featuring Matteo Salvini in Italy. In Latin America, Andrés Manuel López Obrador, a left-wing firebrand, will take office in Mexico in December. Mr Bolsonaro would be a particularly nasty addition to the club. Were he to win, it might put the very survival of democracy in Latin America’s largest country at risk.

Brazilian bitterness

Populists draw on similar grievances. A failing economy is one—and in Brazil the failure has been catastrophic. In the worst recession in its history, GDP per person shrank by 10% in 2014-16 and has yet to recover. The unemployment rate is 12%. The whiff of elite self-dealing and corruption is another grievance—and in Brazil it is a stench. The interlocking investigations known as Lava Jato (Car Wash) have discredited the entire political class. Scores of politicians are under investigation. Michel Temer, who became Brazil’s president in 2016 after his predecessor, Dilma Rousseff, was impeached on unrelated charges, has avoided trial by the supreme court only because congress voted to spare him. Luiz Inácio Lula da Silva, another former president, was jailed for corruption and disqualified from running in the election. Brazilians tell pollsters that the words which best sum up their country are “corruption”, “shame” and “disappointment”.

Mr Bolsonaro has exploited their fury brilliantly. Until the Lava Jato scandals, he was an undistinguished seven-term congressman from the state of Rio de Janeiro. He has a long history of being grossly offensive. He said he would not rape a congresswoman because she was “very ugly”; he said he would prefer a dead son to a gay one; and he suggested that people who live in settlements founded by escaped slaves are fat and lazy. Suddenly that willingness to break taboos is being taken as evidence that he is different from the political hacks in the capital city, Brasília.

To Brazilians desperate to rid themselves of corrupt politicians and murderous drug dealers, Mr Bolsonaro presents himself as a no-nonsense sheriff. An evangelical Christian, he mixes social conservatism with economic liberalism, to which he has recently converted. His main economic adviser is Paulo Guedes, who was educated at the University of Chicago, a bastion of free-market ideas. He favours the privatisation of all Brazil’s state-owned companies and “brutal” simplification of taxes. Mr Bolsonaro proposes to slash the number of ministries from 29 to 15, and to put generals in charge of some of them.

His formula is winning support. Polls give him 28% of the vote and he is the clear front-runner in a crowded field for the first round of the elections on October 7th. This month he was stabbed in the stomach at a rally, which put him in hospital. That only made him more popular—and shielded him from closer scrutiny by the media and his opponents. If he faces Fernando Haddad, the nominee of Lula’s left-wing Workers’ Party (PT) in the second round at the end of the month, many middle- and upper-class voters, who blame Lula and the PT above all for Brazil’s troubles, could be driven into his arms.

The Pinochet temptation

They should not be fooled. In addition to his illiberal social views, Mr Bolsonaro has a worrying admiration for dictatorship. He dedicated his vote to impeach Ms Rousseff to the commander of a unit responsible for 500 cases of torture and 40 murders under the military regime, which governed Brazil from 1964 to 1985. Mr Bolsonaro’s running-mate is Hamilton Mourão, a retired general, who last year, while in uniform, mused that the army might intervene to solve Brazil’s problems. Mr Bolsonaro’s answer to crime is, in effect, to kill more criminals—though, in 2016, police killed over 4,000 people.

Latin America has experimented before with mixing authoritarian politics and liberal economics. Augusto Pinochet, a brutal ruler of Chile between 1973 and 1990, was advised by the free-marketeer “Chicago boys”. They helped lay the ground for today’s relative prosperity in Chile, but at terrible human and social cost. Brazilians have a fatalism about corruption, summed up in the phrase “rouba, mas faz” (“he steals, but he acts”). They should not fall for Mr Bolsonaro—whose dictum might be “they tortured, but they acted”. Latin America has known all sorts of strongmen, most of them awful. For recent proof, look only to the disasters in Venezuela and Nicaragua.

Mr Bolsonaro might not be able to convert his populism into Pinochet-style dictatorship even if he wanted to. But Brazil’s democracy is still young. Even a flirtation with authoritarianism is worrying. All Brazilian presidents need a coalition in congress to pass legislation. Mr Bolsonaro has few political friends. To govern, he could be driven to degrade politics still further, potentially paving the way for someone still worse.

Instead of falling for the vain promises of a dangerous politician in the hope that he can solve all their problems, Brazilians should realise that the task of healing their democracy and reforming their economy will be neither easy nor quick. Some progress has been made—such as a ban on corporate donations to parties and a freeze on federal spending. A lot more reform is needed. Mr Bolsonaro is not the man to provide it.

Siegel vs. Shiller: Is the Stock Market Overvalued?

stock market profits

In August, the current bull market in U.S. stocks became the longest one in history — and there are scant signs of it slowing down. The Dow, S&P 500 and Nasdaq have recently set all-time highs despite uncertainty over the trade war with China and political turmoil in the White House. For investors and other market participants, the big question is this: Is the stock market overvalued and a bear market is long overdue, or are stocks still reasonably priced and more upside is yet to come?

To answer that question, Wharton finance professor Jeremy Siegel and Yale University economics professor Robert Shiller made their cases at the recent conference, “Financial Markets, Volatility and Crises: A Decade Later,” held in New York by Wharton’s Jacobs Levy Equity Management Center for Quantitative Financial Research. Siegel is often seen as a perennial bull and Shiller is viewed as ever the bear. The two, who have been friends since the late 1960s, often give opposing market outlook views separately on business television. It is rare for them to spar in person.

Siegel and Shiller met while graduate students at MIT. “I met Jeremy standing in line for a chest X-ray. They sent us in alphabetical order — Shiller and Siegel,” said Shiller, who is a Nobel laureate and creator of the widely followed CAPE (Cyclically Adjusted Price-to-Earnings) Ratio, also known as the Shiller PE Ratio. “Our books tend to be adjacent to each other in book stores.” What he learned from Siegel was that “it’s possible to view economics as really connected to the real world.”

Shiller pointed out that despite how Wall Street and news outlets typically characterize them, it is not true that Siegel is always bullish and that Shiller is perpetually bearish. “In 2000, we were both bears,” he said. Siegel agreed: “Certainly, we’ve had our disagreements on outlook, but as you said we were both very bearish at the top of the dotcom bubble in 2000.” Siegel is the author of the classic Stocks for the Long Run, often described as one of the best investment books of all time.

Siegel’s Bull Case

Siegel said that since the early 1800s, stocks have brought in a total return after inflation of 6.7% on average annually, far outpacing other asset classes. Bonds came in at 3.5% in terms of historical total real return, Treasury bills at 2.6% and gold at 0.5%, while the dollar has actually depreciated by -1.4% on average yearly. That means $1 invested in stocks over that time would have turned into $1.4 million while the same dollar in bonds would have become $1,599 and T-bills would have been worth $263. Gold clocks in at $3.09. Holding on to that $1 means its value would have fallen to 4.8 cents.

Siegel then examined the stock market’s valuation over time. From 1954 to 2018, the median price-to-earnings or PE ratio (a popular metric in valuing stocks) is 17. There was a dip in PE in the 1970s and 1980s, when double-digit interest rates brought the stock market down. The lowest point was in March 1980, when the PE hit 7.15. The high over this period was in June 1999, when the PE hit 30 during the peak of the dotcom bubble.

Siegel PE chart

Where are we today? “You can see we’re not that high” based on the last 12 months of earnings. Siegel said. “We’re actually just in the low 20s there.” When calculated using this year’s earnings estimate, the PE drops to 18, and further dips to 16 when using 2019 estimated profits, based on the type of earnings he uses. (Siegel prefers to use S&P operating earnings to get his PE ratio.) This calculation includes such things as stock options expenses, pension value changes and others. Siegel doesn’t use the other two types of earnings calculations: firm reported earnings and GAAP (Generally Accepted Accounting Principles).

Firm reported earnings “are the most liberal,” Siegel said, meaning it makes the company’s performance look its best by excluding many things from the profit calculation such as severance costs, litigation expenses and others. GAAP can be misleading. In the 1990s, GAAP went to mark-to-market. “It mandates writedowns and asset impairments whether the asset is sold or not,” he said. “That never used to happen.” And on the flip side, “it doesn’t permit you to write up the asset unless you sell it and prove that there’s actually value — so it’s almost a one-way buy,” Siegel added. “In recessions, you get big writedowns.” He noted that billionaire Warren Buffett, chairman of Berkshire Hathaway, called GAAP’s mark-to-market rules “useless” when used to analyze the ongoing valuation of a company. 

Siegel said that over the last 140 years, the long-term PE ratio averaged around 15, which corresponds to a 6.7% earnings yield, or real return on stocks. He said a PE ratio of 18 forecasts a real return of 5.5% for stocks — 2% dividend, 3.5% real earnings per share (EPS) growth, with 2.5% due to stock buybacks and 1% organic growth. Nominal return is 7.5% including 2% inflation.
This 5.5% return forecast is more than 4.5 percentage points over the 10-year Treasury note, which is the equity risk premium. (The risk premium is the extra return stocks have to bring to make them worth holding since they are more risky than government Treasuries.) This premium historically averaged 3 to 3.5 percentage points. The upshot is that “stocks are overvalued on a long-term basis, but bonds are enormously overvalued on a long-term basis,” Siegel said. “The relative valuation of stocks relative to bonds is actually among the … more favorable in history.”

According to Siegel, the reason why Shiller’s CAPE ratio is more pessimistic is that it assumes there will be reversion to the norm — meaning the market goes high and low but usually reverts to its historical trend. But he questioned this assumption. “Should we go back to 15 as the long-run normal, or CAPE at 16.5 [median return] or so? My feeling is, ‘no, we shouldn’t.’ I say that the warranted PE ratio is higher than history. And one of the reasons for that is indexing at zero cost, which was totally unavailable during the greatest part of this [market] sample.”

Siegel said for much of the stock market’s history, the average investor had to pay higher brokerage costs, bigger bid-ask spreads, etc. “I don’t think it’s unreasonable to assume 1%, 1.5% per year [in transaction costs] back then to do it. Now it’s zero” with ETFs and the like, he noted. “What does this mean? Will you really get 6.7% in the 19th and early 20th century? No. At best, you’re probably getting 5% real … [which] actually corresponds to a 20 PE ratio; 5.5% real would correspond to 18.”

Siegel continued: “So given that costs have gone to zero of maintaining a fully diversified, efficient portfolio, that in and of itself argues in my opinion for a higher equilibrium PE ratio than historical. You could almost call that a new normal of zero transaction costs. By the way, I’m not even talking about interest rates being at record lows, which could maybe inflate the ratio.” Moreover, for every one percentage point drop in dividend yield, there should be a corresponding increase in EPS growth. “That leads to a distortion in Bob’s CAPE, because Bob assumes a constant real growth if there’s going to be a lower dividend yield. Bob actually moved to a total return CAPE — which is different from the CAPE published on [his] website — that makes the correction.”

Shiller’s Bear Case

Shiller presented a chart showing the S&P composite index juxtaposed against the EPS trend line, going back to 1871 (adjusted for before the S&P was created). Siegel and I “agree that history is important. Why is history important? It’s because big movements in these ratios don’t happen very often,” he said. “You want to understand what they mean.”

Shiller S&P chart

Between 1910 and 1930, there was a big jump in earnings, around the time of World War I. “That spike occurred before the U.S. ended the war. You notice the stock market didn’t go up very much. Why didn’t it? Newspapers called it the flood of earnings and they attributed it to the war. A lot of Europeans were buying munitions supplies from the United States. Why didn’t the market go up? [The earnings leap was due to] the war. It was not permanent. After the war was over, the earnings went back down,” Shiller said. “I think the market did the right thing in 1916, which is not to overreact to the sudden burst in earnings.”

Then Shiller noted that earnings jumped again between 1921 and 1929, “but this time, the market went up all the way.” The peak in 1929 was an “overreaction. They didn’t have the skepticism that they had in 1916. Why didn’t they? It was a different atmosphere. It was the roaring 1920s. They just wanted to believe it.” Of course, the Great Depression came shortly after the market crashed. Shiller gave another example. In the 1980s, earnings were going up but stocks were not. “What was the spirit of the times in the 1980s? … Double-digit inflation and really high interest rates,” he said. But then in the 1990s, both earnings and stock prices shot up. Also, leading up to the 2009 crisis, earnings were rising but stock prices didn’t go up as much. “Now, it’s doing it again,” with stocks and earnings rising in tandem, Shiller said.
“The market is filled with real people, and they have their own stories they’re telling and ideas that change from time to time,” Shiller said. “So, should we think like [it’s] 1916 or not? Is this temporary? Well, it’s kind of fuzzy. Probably the reason earnings are up is because they’ve cut corporate profits taxes, and [pro-business] Donald Trump is president. So is Donald Trump permanent? I won’t get into that.” He added that he thinks the market is overreacting again. “We’re launching a trade war,” Shiller said. “It’s likely to be a bad time for the stock market.”

Shiller said the CAPE ratio is calculated by taking the inflation adjusted index price and dividing it by the 10-year average of inflation adjusted earnings to smooth out business cycle fluctuations. It is commonly used to determine whether the stock market is overpriced or not. From 1926 to mid-2017, when the CAPE ratio hit an average low of 8.6, the stock market returned a “very high 9.8% average” annual real return for the S&P 500, he said. When the CAPE is at 33, the average return is less than 1%.

“That’s where we are now,” Shiller said, hastening to add that he’s not predicting a crash. “This is a 10-year forward return.… If you want to predict tomorrow’s price change, it’s very hard. But if you want to predict [what’s going to happen in] five to 10 years, you have a better chance. This is just the reverse of weather forecasting.” However, Shiller remains convinced that stock valuations are “just too high at the present day.” Even if one uses other metrics to substitute for earnings, such as book value, cash flow and others, he noted, the outcome is the same.

Shiller said Siegel has been a “strong critic” of CAPE because it uses firm reported earnings. Shiller did acknowledge that changes in accounting rules over time may have led to a downward bias in reported earnings resulting in an upward bias in CAPE. So Shiller and one of his colleagues replicated Siegel’s results using total return CAPE. They still forecast that “expected returns should be low for the next six to 10 years based on historical” trends.

Moreover, Shiller said Siegel’s earnings data are not squeaky clean. He pointed to a footnote in a 2016 Siegel paper disclosing that “this NIPA (National Income & Product Account) per share profit series is then spliced to the S&P 500 reported earnings series by equating the 10-year averages for 1929-1939 for both series.” For his part, Shiller said that instead of “using econometric techniques to splice two different histories together,” he and his colleague re-evaluated Siegel’s results using actual reported observations. The result is a 25% lower 10-year annualized total return.

Finally, Shiller said Siegel’s argument that modern times call for a re-evaluation of the market sounds similar to one made by economist Irving Fisher in 1930, in a book called The Stock Market Crash — And After, which was “very optimistic about the stock market…. [Fisher] said that now in modern times, investors are much more sophisticated, and they know that the stock market has … outperformed other assets over the long run. They know they can diversify their portfolios, and they even have funds that would help them do that. He predicted a brilliant future for the stock market in 1930. It was a short-run mistake.”

Shiller believes that the spirit of the times informs the market. Back in 1929, there was a “sense of glamour or opportunity” with a big housing boom and a roaring stock market just before the economy turned south. “Right now, we have high real estate prices and high stock prices happening at the same time.” Shiller further pondered, “What is the zeitgeist today? What is the atmosphere? It’s a time in history when we not only have Donald Trump in the U.S., but we have populist leaders around the world, and they are kind of nationalist — it’s also not a friendly time.”

Tech Stock Trends

Siegel responded to Shiller’s comparing him to Fisher by pointing out that the “average cost of mutual funds in Irving Fisher’s day, even up to the 1960s and 1970s, was 2% a year. You are definitely lagging that amount [in portfolio returns]. Today, you don’t lag.” He also pointed out that economists today have a hard time explaining the risk premium. “The equity premium right now is high on a historical basis,” Siegel said. “Ten-year TIPS [Treasury Inflation-Protected Securities] are under 1%, and yet stocks are 5.5% at current valuation. That’s a big margin. Margins should be smaller.”

As for real estate prices going up, Siegel said it’s because of older investors seeking a higher investment return. “We have an aging investor class. Real rates of return are very low. Growth is low, population growth is low, [and] risk aversion is a bit higher [after] two big bear markets in the last 15 years. That’s one reason you have a higher equity risk premium. But real [interest] rates are low and likely to stay low for quite a while. That would cause real estate [prices to rise].” Siegel also pointed out that globally, U.S. real estate is considered “cheap.”

Other countries have gone up much more. “I’m not saying that’s rational. I’m saying it’s not a local bubble.”

Asked how the currently hot FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) would fare in the long run, Siegel compared the situation to the 1990s, when small stocks were believed to outperform in the long term. After further investigation, he found that the small stock premiums from 1929 to the 1990s were mainly due to a 9-year period — starting in 1975 — of “unbelievable outperformance.” The rest of the time, they did not.

“Here was something that was supposed to be a persistent [outperformer, but it only] showed up for less than a decade and then tended to disappear,” Siegel continued. “Is that what’s happening now? We have the FAANG outperformance. Is this a new paradigm, or is it just a streak that is going to come to an end? Now, no one knows for sure. But I did want to mention that other [stocks] have shown a lot of correlation [with FAANG] and streakiness that subsequently disappeared.”

Imperialism Will Be Dangerous for China

Beijing risks blowback as it exports surplus economic capacity to Africa and Asia. 

By Walter Russell Mead

A man walks by a propaganda poster in Beijing, Aug. 28.
A man walks by a propaganda poster in Beijing, Aug. 28. Photo: Andy Wong/Associated Press

China’s real problem isn’t the so-called Thucydides trap, which holds that a rising power like China must clash with an established power like the U.S., the way ancient Athens clashed with Sparta. It was Lenin, not Thucydides, who foresaw the challenge the People’s Republic is now facing: He called it imperialism and said it led to economic collapse and war.

Lenin defined imperialism as a capitalist country’s attempt to find markets and investment opportunities abroad when its domestic economy is awash with excess capital and production capacity. Unless capitalist powers can keep finding new markets abroad to soak up the surplus, Lenin theorized, they would face an economic implosion, throwing millions out of work, bankrupting thousands of companies and wrecking their financial systems. This would unleash revolutionary forces threatening their regimes.

Under these circumstances, there was only one choice: expansion. In the “Age of Imperialism” of the 19th and early-20th centuries, European powers sought to acquire colonies or dependencies where they could market surplus goods and invest surplus capital in massive infrastructure projects.

Ironically, this is exactly where “communist” China stands today. Its home market is glutted by excess manufacturing and construction capacity created through decades of subsidies and runaway lending. Increasingly, neither North America, Europe nor Japan is willing or able to purchase the steel, aluminum and concrete China creates. Nor can China’s massively oversized infrastructure industry find enough projects to keep it busy. Its rulers have responded by attempting to create a “soft” empire in Asia and Africa through the Belt and Road Initiative.

Many analysts hoped that when China’s economy matured, the country would come to look more like the U.S., Europe and Japan. A large, affluent middle class would buy enough goods and services to keep industry humming. A government welfare state would ease the transition to a middle-class society.

That future is now out of reach, key Chinese officials seem to believe. Too many powerful interest groups have too much of a stake in the status quo for Beijing’s policy makers to force wrenching changes on the Chinese economy. But absent major reforms, the danger of a serious economic shock is growing.

The Belt and Road Initiative was designed to sustain continued expansion in the absence of serious economic reform. Chinese merchants, bankers and diplomats combed the developing world for markets and infrastructure projects to keep China Inc. solvent. In a 2014 article in the South China Morning Post, a Chinese official said one objective of the BRI is the “transfer of overcapacity overseas.” Call it “imperialism with Chinese characteristics.”

But as Lenin observed a century ago, the attempt to export overcapacity to avoid chaos at home can lead to conflict abroad. He predicted rival empires would clash over markets, but other dynamics also make this strategy hazardous. Nationalist politicians resist “development” projects that saddle their countries with huge debts to the imperialist power. As a result, imperialism is a road to ruin.

China’s problems today are following this pattern. Pakistan, the largest recipient of BRI financing, thinks the terms are unfair and wants to renegotiate. Malaysia, the second largest BRI target, wants to scale back its participation since pro-China politicians were swept out of office. Myanmar and Nepal have canceled BRI projects. After Sri Lanka was forced to grant China a 99-year lease on the Hambantota Port to repay Chinese loans, countries across Asia and Africa started rereading the fine print of their contracts, muttering about unequal treaties.

Meanwhile, China’s mercantilist trade policies—the subsidies, the intellectual-property theft, and the coordinated national efforts to identify new target industries and make China dominant in them—are keeping Europe and Japan in Washington’s embrace despite their dislike of President Trump.

China’s chief problem isn’t U.S. resistance to its rise. It is that the internal dynamics of its economic system force its rulers to choose between putting China through a wrenching and destabilizing economic adjustment, or else pursuing an expansionist development policy that will lead to conflict and isolation abroad. Lenin thought that capitalist countries in China’s position were doomed to a series of wars and revolutions.

Fortunately, Lenin was wrong. Seventy years of Western history since World War II show that with the right economic policies, a mix of rising purchasing power and international economic integration can transcend the imperialist dynamics of the 19th and early 20th centuries. But unless China can learn from those examples, it will remain caught in the “Lenin trap” in which its strategy for continued domestic stability produces an ever more powerful anti-China coalition around the world.

What is behind the global stock market sell-off?

A mix of higher bond yields and growth worries take their toll

Robin Wigglesworth, US Markets Editor

The Wall Street fall carried echoes of February’s 'Volmageddon', when the S&P 500 suffered a 10 per cent correction © FT Montage

A sell-off that saw tech stocks drive the S&P 500 on Wednesday to its worst one-day drop since February rippled across global markets on Thursday.

The severe drop on Wall Street carried echoes of February’s “Volmageddon”, when the S&P 500 suffered one of its swiftest 10 per cent corrections and raised questions over whether the almost decade-long bull market was at risk. While there was no immediate trigger for the sell-off, here are some of the forces at play in the current market turmoil.

Rising bond yields

Undoubtedly the proximate cause of the stock market reversal. Last week’s bond rout was caused by rising economic optimism, but the severity of the reaction in fixed income — the 10-year Treasury yield raced to a seven-year high of 3.25 per cent — has been sufficient to unnerve equities as well.

Bonds have remained under pressure this week, but not nearly to the same extent. Analysts and investors say yields are not high enough to unduly worry them, and moves in the Treasury market were relatively muted until the equity rout worsened on Wednesday afternoon. The steepness of the drop prompted investors to dive back into the relative safety of US government debt. The yield on the 10-year bond was at 3.17 per cent in London.

“Higher interest rates typically bring on tighter financial conditions which could dampen growth going forward and equity markets are reacting to that,” noted Charlie Ripley, a senior investment strategist for Allianz Investment Management.

So rising yields might have set the stage for the sell-off, but probably cannot shoulder the blame for its ferocity.

Short-volatility bets

The February turmoil also triggered rising yields, but was exacerbated by the collapse of two exchange-traded notes that bet on stock markets remaining tranquil through complex derivatives contracts called Vix futures.

When volatility jumped these funds — and other traders that were “shorting” volatility — were ripped to shreds, and caused volatility to spiral even higher as they sought to cover their positions. That bled back into the stock market through S&P futures and caused further declines.

A similar dynamic might have come into play this week. Data from the Commodity Futures Trading Commission indicate that investors are once again shorting Vix futures to the greatest degree since January, and the CBOE’s volatility-of-volatility index has rocketed to its highest since February.

“The US market sell-off last night spooked sentiment and rekindled memories of similar trading sessions at the beginning of the year,” said Medha Samant, investment director for Asian equities at Fidelity International.

However, one of the Vix ETNs that fuelled February’s “Volmageddon” is dead and the other is a shadow of its former self, and derivatives traders say that the market is on the whole not quite the coiled spring it was at the start of the year.

Stock market rotation

One of the most notable developments in the US of late has been the abrupt reversal of winners and losers. Unloved stocks that have lagged behind the 2018 rally have performed much better, while the biggest casualties have been previously high-flying companies and sectors.

Fast-growing technology stocks have been the go-to investment of fund managers in recent years, given that economic growth has been far from stellar. But with the US economy now strengthening, some investors appear to be rotating into cheaper “value” stocks that will benefit from the uplift.

Meanwhile, bond yields are used to discount the future value of cash flows. The lower they are, the better they are for assets with long duration — such as 30-year Treasuries, or equities, which are (in theory) perpetual securities.

Given the lack of dividends and higher valuations, many tech stocks are arguably the longest-duration asset in the world, “it’s perfectly reasonable that they would eventually succumb to rising rates,” strategists at Morgan Stanley note.

Global growth outlook

The extent of the praise that Fed chair Jay Powell heaped on the US economy last week surprised some, but the American economy’s outperformance has been one of the key trends for markets this year. However, it has come as much of the rest of the world has slowed.

Mario Draghi, president of the European Central Bank, has pointed to rising protectionism as the “major source of uncertainty” to the eurozone economy, where recent business surveys and official manufacturing data showed falling confidence and slowing export sales. The International Monetary Fund this week cut its growth forecasts for most countries for this year and in 2019.

“For much of 2018, the US economy has been oblivious to a turn in the global economic cycle, and the US equity market has been unaffected as emerging market equities and currencies have come under pressure,” noted Kit Juckes, a strategist at Société Générale. “This week has seen the S&P, and the Nasdaq, sit up and pay attention to what’s going on.”

While tech stocks led the sell-off, energy was the fourth worst performing sector as the oil price tumbled. Brent fell 2.2 per cent on Wednesday and was 1.2 per cent weaker on Thursday morning in London.

Systematic strategies 

There are many computer-powered investment strategies that systematically scale their market exposure according to volatility. So when markets turn choppier they sell, and when turbulence simmers down they buy.
How quickly they respond to volatility varies greatly by strategy, and systematic fund managers insist that they barely respond to shorter bursts of volatility. But some analysts and investors argue that they can nonetheless exacerbate both routs and rallies.
The three main types are risk parity funds, commodity trading advisers — a kind of trend-following hedge fund — and “variable annuity” insurance accounts with a fixed volatility target. Numbers vary but analysts put their total assets under management at about $1tn. These funds tend to rebalance in the last hour of the trading day, which might explain why the sell-off seemed to accelerate into the closing bell.
But exchange traded funds and many other quant strategies also adjust positions at the end of the day, which pools activity into a narrow window and encourages other investors to do so as well, so the end-of-day tumble is not necessarily evidence of systematic, volatility-targeting funds exacerbating the turmoil.

Copper conundrum: price plummets despite strong Chinese demand

Metal moved in tandem with steel for most of this year but now their paths diverge

Henry Sanderson

Concerns about the US-China trade war have hit the price of copper this year — and yet a key indicator of the metal’s demand remains healthy.

The commodity, often called Dr Copper for its ability to forecast global economic growth, has fallen 13 per cent to trade at $6,262 a tonne.

Despite the price plummeting, analysts say physical demand for copper in China, the world’s largest consumer, is strong. The price to buy copper in China, as measured by the local premium, has risen over the past month.

But in China the price of steel, which has moved in tandem with copper for most of this year, has continued to rise. Both metals are used in construction.

“We’ve never seen this degree of divergence sustained for so long,” said Ian Roper, an analyst at SMM, a Chinese metals consultancy in Singapore. “Underlying fundamentals today are quite good.”

That is a sentiment shared by the largest copper miners such as Freeport-McMoRan and Antofagasta, which say demand for copper from their customers remains strong.

The sell-off in copper prices has instead been driven by traders and speculators more concerned about the global economic impact of a US-Sino trade tussle.

“Escalating trade rhetoric from the US administration was sufficient to put an end to copper’s party,” according to analysts at Wood Mackenzie.

Going forward the question will be how much the trade dispute — and the rhetoric — starts to eat into real copper demand in China.

Analysts at BMO Capital Markets expect growth in copper demand to fall to 2.6 per cent in 2019 from an expected 4.2 per cent this year. Traders may be right to be cautious.

Emerging Markets’ Shifting Bottom Line

Gene Frieda  

currency exchange office

LONDON – One truism of the last three decades is that emerging markets are a leveraged play on global growth: they outperform when developed economies are growing, but they are susceptible to sharp downturns when global conditions are less favorable. This more or less remains true. But when considering emerging-market investment opportunities in the years ahead, one must also understand the changes that have followed developed-market financial crises and a larger shift in the geopolitical landscape.

On one hand, many emerging economies have become more resilient and are no longer simply riding on developed markets’ coattails. On the other hand, juxtaposed against these positive developments are a fresh set of challenges, namely increasingly pro-cyclical liquidity provision by market makers, the rise of populism, and a temptation to rely on currency depreciation as a substitute for structural reforms.

In light of these new realities, the sell-off of emerging-market assets this year actually means that value and risks are better aligned. To be sure, the many risks facing emerging markets still call for a highly differentiated stance, as market illiquidity can magnify the impact of shocks on prices. Yet, in addition to higher yields, three secular trends underpin the case for investing in emerging markets across global business cycles.

First, emerging-market economies have climbed up the development and ratings scales over the past few decades, reducing significantly their dependence on foreign borrowing. Second, most emerging markets have moved to floating exchange rates, which help to cushion growth from external shocks such as unanticipated monetary-policy tightening in the United States. And, most important, most emerging-market central banks, having established strong track records of meeting inflation targets, no longer have to counter large exchange-rate depreciations with draconian interest-rate hikes. As such, domestic bond markets are better insulated, which in turn allows governments to make use of counter-cyclical fiscal policies to stabilize growth and service debts.

Several other recent developments are similarly encouraging. For starters, monetary-policy normalization in the developed economies – a process that has now been underway for 30 months in the US – looks likely to continue at a slow pace, owing to adverse demographics, high debt levels, and weak productivity growth. Low equilibrium interest rates are an important anchor for local and external debt prices in emerging markets. So, too, is the lack of inflation pressure globally.

At the same time, emerging-market growth should start to become less sensitive to US interest rates and the dollar,given lower external borrowing needs, the relative lack of borrowing in dollars specifically, and reduced dependence on commodity exports. While Argentina and Turkey are noteworthy exceptions, most major emerging-market economies have been liberated from the “original sin” of issuing dollar-denominated debt, and thus can borrow in their own currency.

That said, each of these trends has implications that must also be factored into investment decisions. For starters, while liberation from the “original sin” mitigates the need to tighten policy pro-cyclically during externally driven shocks, it also means that the burden of any requisite adjustments will fall disproportionately on exchange rates, rather than on domestic interest rates. As a result, exchange-rate depreciation could mitigate the fallout for growth, particularly in countries with credible inflation-targeting regimes.

Second, weaker potential growth – the counterpart to lower equilibrium interest rates – has created fertile ground for populism in countries lacking robust institutions. And populist policies will ultimately hinder growth. So, while risks may be lower on average for emerging markets, this tail risk remains high.

Third, while the relative illiquidity of emerging markets has always demanded extra care, the liquidity risk premium for emerging-market assets may be more pro-cyclical than in the past. At the same time that regulatory changes have reduced the intermediation capacity of traditional liquidity providers, new, computer-driven intermediaries with negligible capital buffers have made it easier to flee the market when volatility rises.

Finally, the success of emerging markets in floating their exchange rates, combined with the low-growth environment, has indirectly led to a proliferation of nationalist, protectionist policies in the developed economies. With faster global growth, exchange rates would bear the burden of domestic macro adjustments, and allow for a re-slicing of the (larger) growth pie through currency movements. But with the growth potential now lower, political sensitivities to exchange rate-driven adjustments are more pronounced.

This raises the risk of a feedback loop between emerging-market currency depreciations and developed-market political responses, which include tariffs and other trade measures designed to protect a shrinking pie. Worse still, such vicious cycles are difficult to break, because emerging-market currencies typically weaken when growth is threatened.

Today, the hierarchy of emerging-market assets has been flipped on its head. In the past, emerging-market governments defended exchange-rate pegs, which meant that stress was borne first by local interest rates rising sharply, and then through wider external debt spreads as currency pegs came under pressure. Now, currencies are the primary buffers mitigating the fallout on emerging-market debt and growth. This may imply larger, but less disruptive, currency adjustments than in the past.

From an investment perspective, the good news is that the traditional perils of investing in emerging markets have been mitigated. Many emerging markets have become less vulnerable to external financing shocks and the threat of sharp, unanticipated changes in developed-economy monetary policies. Despite lower potential growth and equilibrium interest rates in developed economies, average absolute returns for emerging markets may be no lower than in the past.

The bad news is that liquidity disruptions are likely to occur more frequently, requiring careful attention to the size of illiquid exposures in periods of low volatility. Lower potential growth also raises the risk of populist policies, which would most likely have to be offset with higher spreads.

Gene Frieda is an executive vice president and global strategist for PIMCO.